Receipt of money prior to the delivery of the service or goods is the receipt of “unearned revenue” which has its own classification under GAAP and the U.S. Internal Revenue Service regulations. This is not a universal method of tax treatment – and it is another reason why companies should favorably consider establishing a U.S. branch or affiliate through which to transact international business.
The law known as the Tax Cuts and Jobs Act of 20171 amended Internal Revenue Code
§451 to allow accrual-basis taxpayers to defer recognizing income until it is taken into account in their applicable financial statements as defined by §451(b)(3). The taxpayer makes an election to defer the income. This rule can eliminate some book-tax timing differences regarding unearned revenue, also known as deferred revenue. Taxpayers have relied on Rev. Proc. 2004-34 to defer the recognition of income for tax purposes on prepayments. In general, taxpayers were able to defer income from advance payments for tax purposes if they (1) adopted the accrual method and (2) deferred the income for financial reporting purposes for not longer than the next tax year. Taxpayers are able to defer income recognition based on how the income is recognized in their applicable financial statements as a result of the amendment to §451. However, there is no such exception for advance payments of rent, insurance premiums, and other payments.2 Further, taxpayers generally are not able to defer the income recognition beyond the year following the year of receipt. The Act expires December 31, 2025 though some provisions of the Code will not be effected.
Unearned revenue, sometimes referred to as deferred revenue, is payment received by a company from a customer for products or services that will be delivered at some point in the future. The term is used in accrual accounting, in which revenue is recognized only when the payment has been received by a company AND the products or services have not yet been delivered to the customer.
Accounting reporting principles state that unearned revenue is a liability for a company that has received payment (thus creating a liability) but which has not yet completed work or delivered goods. The rationale behind this is that despite the company receiving payment from a customer, it still owes the delivery of a product or service. If the company fails to deliver the promised product or service or a customer cancels the order, the company will owe the money paid by the customer.
Generally, unearned revenues are classified as short-term liabilities because the obligation is typically fulfilled within a period of less than a year. However, in some cases, when the delivery of the goods or services may take more than a year, the respective unearned revenue may be recognized as a long-term liability.
The Internal Revenue Code provides that, generally, gross income means all income from whatever source derived. §162 provides a deduction for all ordinary and necessary expenses paid or incurred in carrying on a business. Under GAAP, the accrual method of accounting is required where revenue and expense straddle more than one tax year, and, therefore, expenses and revenues should be properly reflected in each accounting period to avoid distorting income for any one accounting period.
References
1 The TCJA lowered most individual income tax rates, including the top marginal rate from
39.6 to 37 percent. The law maintained the seven-bracket rate structure, but the income thresholds were updated. TCJA increased the standard deduction to $12,400 for single filers and $24,800 for married filers (tax year 2020), compared with $6,500 (single) and $9,550 (married) under prior law. The bill eliminated the personal exemption and a variety of other miscellaneous deductions along with limiting certain itemized deductions like the state and local tax (SALT) deduction, mortgage interest deduction (MID), and charitable contribution deduction. TCJA increased the Child Tax Credit (CTC) from $1,000 to $2,000—the first
$1,400 of which is refundable—and increased the income thresholds from $110,000 to
$400,000. The TCJA lowered the corporate income tax (CIT) rate from 35 to 21 percent starting in 2018. The measure also allows full and immediate expensing of short-lived capital investments for five years and increases the section 179 expensing cap from $500,000 to $1 million. The bill eliminated or curtailed a variety of business taxes and expenditures, including the deductibility of net interest, net operating loss carrybacks and carryforwards, and the corporate alternative minimum tax (AMT). Additionally, the TCJA moved the United States toward a territorial tax system and instituted rules to prevent base erosion.
2 Under §451(c)(4)(B), advance payments for the following items are not eligible for deferral:
(1) rent; (2) insurance premiums; (3) payments with respect to financial instruments; (4) payments with respect to warranty or guarantee contracts under which a third party is the primary obligor; (5) payments subject to §871(a), 881, 1441, or 1442; and (6) payments to which §83 applies.
Regina Mundi Global Advisors 